This paper investigates empirically the drivers of financial imbalances ahead of the global financial crisis. Three factors may have contributed to the build-up of financial imbalances: (i) rising global imbalances (capital flows), (ii) monetary policy that might have been too loose, (iii) inadequate supervision and regulation. Panel data regressions are performed for OECD countries from 1999 to 2007, so as to shed light on the relative importance of these factors, as well as the extent to which these factors might have interacted in fueling the build-up. We find that the build-up of financial imbalances was driven by capital inflows and an associated compression of the spread between long and short rates. The effect of capital inflows on the build-up is amplified where the supervisory and regulatory environment was relatively weak. We find that, by contrast, differences in monetary policy cannot account for differences across countries in the build-up of financial imbalances ahead of the crisis. The crisis that began as the U.S. “subprime” crisis in the summer of 2007 spread to a number of other advanced economies through a combination of direct exposures to subprime assets, the gradual loss of confidence in a number of asset classes and the drying-up of wholesale financial markets. In this process, it came to expose “home-grown” financial imbalances in a number of advanced economies, typically characterized by an overreliance on wholesale funding sources by the banking system and asset bubbles in residential property markets.

Three years after the onset of the crisis, there is still no full agreement among policymakers and researchers on what caused the build-up of financial imbalances globally. While most commentators concede that supervision and regulation were lacking with hindsight and efforts to strengthen regulation are well underway, strong disagreement persists on whether it was overly accommodative monetary policy from 2001 that fueled the build-up (Taylor, 2007, White, 2009) or whether the widening global imbalances and associated capital flows were the root cause of the build-up of financial imbalances across advanced economies (e.g., Bernanke, 2009, King, 2010, Portes, 2009). As argued by some (e.g., Acharya and Richardson, 2009, Obstfeld and Rogoff, 2009), it may have been a combination of accommodative monetary policy and growing global imbalances that caused the build-up. But even if this were to be so, an empirical determination of these factors’ relative contribution remains an important and unfinished task.